Seeking More Than One Factor Can Boost Returns

One of the current trends within the investment industry is to focus on factors. Also referred to by the monikers “smart beta” and “strategic beta,” factor investing involves buying stocks with certain, quantifiable characteristics. Factors include low valuation, small size, price momentum and many others.

There has also been a proliferation of factor exchange-traded funds (ETFs). Even Vanguard joined the party earlier this year with its own factor ETFs. Some of these offerings from the various ETF providers have a singular focus [e.g., iShares Edge MSCI USA Momentum Factor ETF (MTUM)], while others use several factors [e.g., SPDR MSCI USA StrategicFactorsSM ETF (QUS)]. With this proliferation, a natural question emerges: Which is better?

A new study sought out the answer. Its insight has relevance for both ETF investors and those of you who prefer to invest in individual stocks. Before going into the details and discussing how it relates to what we do with the AAII portfolios, I’ll jump right to the conclusion: returns are better if factors are mixed rather than targeted on a single basis. In other words, don’t just focus on value, but combine value with additional factors. The same goes for many other factors, such as momentum and size.

The study’s authors used six factors: size (smaller is better), value (cheaper is better), profitability (higher is better), investment (less relative growth in assets is better), momentum (stronger relative price performance is better) and market beta (the market’s volatility). Five of them are used in professors Eugene Fama and Kenneth French’s five-factor model for explaining stock price returns. Momentum is the sixth factor that rests outside of the model, though Fama and French “augmented” their model with it due to “popular demand” (their words, not mine).

The hypothetical portfolios used were first constructed from stocks ranking favorably on a specific factor. When these portfolios were adjusted to exclude stocks that ranked unfavorably on one or more additional factors, monthly returns improved. The improvement held true for each factor. The trade-off was that as the number of factors increased, the number of stocks held fell.

The value factor portfolio exemplifies the impact. Monthly returns rose from 0.23% per month (for the period of 1963 through 2017) when just value was required to 0.69% when size, profitability, investment and momentum were also required. Simultaneously, the average number of stocks held fell from 302 to just 13. What the averages don’t reveal is how many times the fully enhanced portfolio found few or no stocks. The change in volatility wasn’t reported.

The idea of combining factors is nothing new; portfolio managers and individual investors have been doing this for years. Even the AAII portfolios combine factors. Our Model Shadow Stock Portfolio combines size and value. AAII Dividend Investing uses yield and value. Our VMQ Stocks portfolio seeks out value, momentum and quality.

For those of you investing in individual stocks, the lesson is to seek out stocks with more than one attractive trait. If you’re a value investor, also seek underlying quality, momentum, yield, etc. If you use technical analysis, incorporate fundamental analysis. If your preference is growth, investment or profitability can play a role. The basic idea is to find more than one reason why the stock should rise in price. In doing so, be careful not to be so restrictive that you’re left with only a few stocks to invest in. As investors, we don’t need stocks to be perfect, rather we just need them to be priced below what someone else might be willing to pay for them in the future.